Dividends are considered an important criterion for investors who want a recurring and consistent stream of income. Dividends represent the distribution of corporate profits to eligible shareholders. Larger, more established companies with more predictable profits are often the best dividend payers. There are two main types of dividends: cash or stock (scrip dividend).
Paying dividends allows companies to share their profits with shareholders, thanking shareholders for their ongoing support via higher returns and incentivising them to continue holding the stocks. Consistent dividends are often viewed by investors as a sign of a company’s strength and that the company’s management has positive expectations around future earnings growth. This makes the company more attractive to investors, which helps to drive the stock price higher.
Startups and other high-growth companies, such as those in the technology or biotech sectors, may not offer regular dividends. Because these companies may be in the early stages of development and incur high costs (as well as losses) attributed to research and development, business expansion, and operational activities, they may not have sufficient funds to issue dividends. Even profit-making early- to mid-stage companies avoid making dividend payments if they are aiming for higher-than-average growth and expansion and want to invest their profits back into their business rather than paying dividends.
Berkshire Hathaway on dividends: Love to receive but do not give
Berkshire Hathaway’s “Annual Shareholder Letter 2012” explains why it relishes the dividends we receive from most of the stocks that Berkshire owns, but has not and will not pay dividends.
- A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or otherwise widen the economic moat separating the company from its competitors.
- Next, it is to search for acquisitions unrelated to their current businesses with a simple test: Can Berkshire effect a transaction that is likely to leave the shareholders wealthier on a per-share basis than they were prior to the acquisition?
- Share repurchases are sensible when its shares sell at a meaningful discount to conservatively calculated intrinsic value (undervalued). In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value. Berkshire currently defines its buyback threshold as 120% of book value.
Above are the three ways that Berkshire’s capital will be deployed instead of giving dividends. If none of the three options looks appealing now, it intends to continue to add its stockpile of cash and wait until one of the options becomes attractive.
Buffett loves dividend-paying stocks for the same reason he loves most of the businesses Berkshire owns. They generate a consistent source of cash flow that Berkshire can deploy in whatever way it sees fit.
Berkshire’s desire for dividends and not giving dividends stems from its strong belief that it can generate much higher returns with cash over the long term.
Bottom line: What are we investing in?
We invest based on the quality of the company and the management, their ability to widen their competitive moat and grow. Dividends are the results of their execution.
There are lots of disruptions, competition and liberalisation happening:
- Online shopping has been affecting retailers and shopping malls.
- Companies implementing hybrid work arrangements affect office space providers.
- E-commerce companies create their own logistics and new logistics service providers; affecting postal service and courier service delivery. The latter is also affected by emails, faster electronic communications as well as the desire to go green.
- Various electronic communication channels (WhatsApp voice and video, Zoom, etc) disrupt telco’s international direct dialling (IDD), landline businesses.
- Online stockbrokers affect traditional brokerages.
- Ride-hailing services affect taxi businesses.
- Airbnb affects hotels.
- Online news channels, blogs and social media affect newspapers.
- Netflix and YouTube affect national broadcasters.
- Liberalisation of the sectors (telcos, banks, insurance companies, stockbrokers) as governments issue more licenses and welcome foreign companies’ participation to compete and provide consumers better quality service.
- Crypto transfers are disrupting wire money transfers.
- Fintech and crypto are disrupting banks and other financial service providers.
Many well-established companies paid dividends as they were in strong competitive market leadership positions (General Electric, Ford, General Motors). However, as its competitive position deteriorates, it should have reinvested more to defend its competitive position than to continue to pay dividends (albeit lower dividends. Shareholders (including business owners as majority shareholders) grow accustomed to their dividends. Management sees it as an obligation to give dividends. There are many instances where incumbents have to turn to their shareholders for money (taking back the dividends they have been giving) to improve their competitiveness. Others are finding it difficult to compete.
On the other hand, young startups, challenging the status quo, compete aggressively to out-win the incumbents with their capital and cash flows. The shareholders investing in these companies do not expect dividends as they expect them to invest to compete.
Example 1 – Walmart: It operates a chain of hypermarkets (also called supercenters), discount department stores, and grocery stores. Its market position has been strong until Amazon and other e-commerce companies grow and threaten its market position. Its dividend yields have been reducing. Amazon has not paid any dividends yet.
Example 2: Singapore Post: It started as the sole postal service provider. For many years, it has been giving consistent dividends. However, its financial position has been deteriorating and slashing its dividends; reducing its payout ratio. Its share price collapsed from its high in 2015 and has been languishing at a low since. Today, it is providing e-Commerce logistics and expanding internationally.
Focus on the quality of the investments
Dividends should not be a key determinant for the selection of our investments nor should a consistently high dividend yield be taken as a sign of the companies’ quality.
The quality of the companies, their management team and their ability to keep widening the competitive moat matter the most. There will be more disruptions, competition and liberalisations. The life cycles of products and services are getting shorter. Companies cannot be complacent and we as investors can assume that their competitive moat is unassailable.
Investors should evaluate based on potential total returns (share price appreciation and dividends) than just dividend yield. The same applies to gold, commodities, crypto other than equities. We are selling ourselves short by looking mainly at dividends but possibly in danger when the companies’ competitiveness is weakening over time.
Do not keep holding the stocks and assume dividends will be paid out consistently.
Hence, instead, ensure that the companies that are paying dividends are high quality and competitive.
Use of dividends by shareholders
There are two uses for dividends:
- Re-invest the dividends for better returns like Buffett with Berkshire
It can be re-invested back to the same investment through scrip dividends or invested in other companies that offer better returns.
- Provide recurring income to spend
Lot size is getting smaller and more are offering fractional share trading. These will allow shareholders to trim their positions to spend. Also, experienced investors can take advantage of the volatility to sell high and buy low later. These can reduce the importance of dividends.
Additional consideration: Tax implications
Dividends are preferred by shareholders for tax reasons because they are treated as tax-free income for shareholders in many countries. Conversely, capital gains realized through the sale of a share whose price has increased are considered taxable income. Traders who look for short-term gains may also prefer getting dividend payments that offer instant tax-free gains.